Why do people prefer living annuities to life annuities? 

By: Paul Nixon, head of behavioural finance at Momentum Investments Group 

For many people, a living annuity is the preferred choice for retirement. Why more people don’t end up securing more of their retirement with a life annuity, however, is more of a behavioural finance problem than an economics problem.  

This is simply because, in general, people don’t maximise utility (seeking to achieve the highest level of satisfaction from their economic decisions). That is because there are other things at play when making the important decision of whether to buy a life annuity or a living annuity.  

The decisions we make about our money often consider feelings and emotions. We find it easier to visualise getting run over by a bus after we’ve just purchased a fixed annuity, becoming suddenly aware of the loss of capital in the event of premature death, than visualising being old and having no money¹. The latter scenario is, in fact, far more likely.  

Several other factors should factor into your client discussions when they are considering their options at retirement:  

1. Overconfidence in managing our own money: There may be a level of overconfidence certain people may have in generating returns over and above those offered by fixed annuities. However, Momentum Investments studied the behaviour tax (lower investment return due to switching behaviour) and confirmed that 75% of this behaviour tax occurs in the Retirement Income Option, our living annuity².  

2. Control in managing our money: People have a deep and innate need to control their surroundings. Converting a lump sum into an income stream may be perceived as a loss of control. This also explains the behaviour of resigning from a company before retirement to access pension savings to access a lump sum (even though it is more heavily taxed).  

3. Framing of annuity choices: Studies have shown that when annuities are framed in the context of an investment, highlighting aspects like returns and liquidity, retirees tend to prefer a savings balance (living annuity) over a life annuity. However, when income is presented in consumption terms, emphasising sustainability of consumption requirements, they tend to choose the life annuity.  

4. Loss aversion: An article that appeared in the Financial Times, ‘Annuities: Gambling on Your Life³’, sums this up nicely. The mere prospect of dying soon after purchasing an annuity will immediately place people in a loss-averse state, which will impact their behaviour. There may also be fears about the rising costs of care in retirement that could result in fluctuating consumption patterns and having to rely on family to bridge these gaps.  

5. Mental accounting: Money is fungible. But people get different utilities or benefits depending on what the money is earmarked for. The mental account opened for life annuities is sometimes seen as a gamble (beating life expectancy), which will lead to a natural aversion to choosing a life annuity.   

6. Bequest motives: It is human nature to desire leaving a legacy as a manner in which to capture even a slight sense of immortality. Any threat to the longevity of retirement savings (such as being forfeited) will not be favourable. This factor is similar to loss aversion.  

7. Mortality salience: We don’t like thinking about our mortality and discussions around how long we are expected to live can make us uncomfortable.  

8. The growing sandwich generation: This is more of a societal trend, but the growing tendency of parents to move back in with their children, who have children of their own and who are also dependent on them, creates the ‘sandwich’, placing additional pressure on cash flows, which may explain why fixed annuities don’t match higher required withdrawal rates.  

The bias most easily leveraged from the list above to the benefit of clients is mental accounting. Different income needs for clients are easily matched with different mental accounts and the more certain that need is (such as healthcare or housing, for example), the more appropriate it would be to fund this need with more certainty, such as that offered by fixed annuities. This also assists in the planning process in the build-up to retirement. Instead of a daunting shortfall, each bucket is funded before the next, thereby providing more psychological utility en route as each becomes funded.  

Luckily these days, the choice is not one or the other. People can use the Guaranteed Annuity Portfolio to allocate a portion of their retirement money to the Retirement Income Option, the living annuity available on the Momentum Wealth platform, to provide a guaranteed income for life. This allows clients to blend the best of the living annuity and life annuity to extract more years out of their savings.